Four signals from the Fed you don't want to miss

COVID-19 has changed the world and the repercussions will be felt in the bond market for several years. But the message from markets is murky, at best. We're at the tipping point for a kaleidoscope of possible outcomes and investors have all eyes on the Federal Reserve. 

"From our team, we certainly see a path towards the 10-year (US Treasury yields) going above 2% sometime in 2022. We certainly see a path going below 1% sometime in 2022. So, much is contingent on, unfortunately, COVID. It's not going to be a quick exit from there," said Scott Solomon, Associate Portfolio Manager for T. Rowe Price's Dynamic Global Bond Fund. 

Solomon and I recently chatted about what signals the bond market is sending. Bonds are notoriously influential across broader equity markets, even supposedly forcing the hand of the US Central Bank's policymakers in 2013's taper tantrum. 

But lately, bond markets haven't been behaving the way people expect. Hence, the murky messages. In part, this is because the Fed has been holding interest rates steady in the face of rising inflation metrics. 

A rate hike and some tapering of Quantitative Easing (QE) could signal the end of the party for equities. 

Solomon is keeping a close watch on a few key things, such as how quickly the Fed could turn hawkish and whether peak dovishness is enough to gut investor optimism. 

"Basically, they made a hawkish pivot back in June or so. But they're certainly not running a hawkish or tightening monetary policy right now. Did they hit peak dovishness? Yeah, certainly. And what the bond market took that as is....the Fed has just ruined the party. Just as we've hit peak growth, now they're going to start tapering, and that's going to be bad for the economy. 

The Fed's actions are "going to really cut the cycle much shorter than we were expecting. And that's one reason you're seeing a pretty significant fall in yields," he said. 

What should you look out for? 

1. Vaccine rates are the real clincher. 

The global vaccination rate under the reign of the Delta wave is the key indicator of a sustained reopening 

"The UK has been probably a really great case study for the rest of the world. They've had pretty strong vaccine rates. They had a pretty significant breakout with COVID over the last couple of months. ... The very positive thing was the hospitalisation stayed extremely low for the UK. So, that shows the world that... Yes, we don't have to lock down everything. As long as people get vaccinated, they'll remain, for the most part, healthy," said Solomon. 

2. The Fed's next move on interest rates

"We certainly don't feel like, or I certainly don't feel like just because the Fed made a hawkish pivot that it's going to kill growth immediately," said Solomon. 

The most recent Federal Reserve "dot-plot" - the infamous chart of Federal Open Market Committee votes on rate hike expectation - shows a strong sentiment towards hikes in 2023-24. But that isn't necessarily bad news.  

"Just because the Fed is hiking and tightening doesn't mean we're in a scenario where risk assets are bad, and it's necessary for the yield curve to flatten. What does end up hurting the economy and financial markets is when the Fed gets on autopilot and just starts hiking one after another," he said. 

3. Whether inflation is here to stay

Last week, data out of the US showed inflation hit 13-year highs. The great inflation debate of late is whether inflation is transitory or sustained.

"I wouldn't necessarily say there will be a huge inflation overshoot, but some sort of persistent inflation is certainly here to stay," said Solomon. 

Solomon sees signs of both kinds of inflation. In some sectors, inflation figures will subside while other sectors - in part plagued by supply chain issues - will continue for several years.

"There are certainly many sectors that are definitely transitory. Look at used cars - they're not going to continue growing at 10% a month," he said. 

"(But) there's a saying that building a new semiconductor plant is not rocket science: it's harder. These are not quick fixes. They can't just turn around and add capacity to the semiconductor market in six months or eight months. It's a two to three year CapEx cycle. So, it's going to take a long time for some of these backlogs to work through."

4. QE tapering 

Looking back over the past 20 years of monetary policy and the bond market, the biggest change has been the introduction of QE. Massive bond-buying programs, to the tune of US$120 billion in monthly purchases has meant the bond market is never lacking in buyers. 

"There's always another buyer there. If they want to sell their bonds, someone's going to come along and buy them. Typically, it's central banks," said Solomon. 

"It wasn’t so much the mechanics of purchasing bonds that impacted prices. It was the fact that the Fed was there and willing to buy that certainly did impact those prices," he said. 

Employment data, which was also released last week, has been a key leading indicator for potential QE tapering. Experts are waiting for the September meeting of the Federal Reserve to see if a crucial announcement on tapering will be made. 

So, what's the opportunity? 

The most compelling reason to dive into fixed income, said Solomon, is because you want something to go up in your portfolio - increase in price - when everything else is going down. It's both a safe haven and an opportunity for unexpected returns. 

"So, duration risk, or interest rate risk, is obviously going to be the biggest risk and probably the most misunderstood aspect of the fixed income market," said Solomon. 

"I get questions all the time asking "Well, why am I going to buy a bond when it pays 1% interest?" Well, that's not really why you're buying it anymore."

" And typically when there's (a downturn) just like the pandemic, stocks sell-off pretty significantly, bonds rally. So you have that counterbalance in your portfolio. 

Headline figures can be misleading. One of the trickiest concepts for investors to grasp is how small movements in bond markets have BIG impacts. 

"I think people forget that a lot of times. They just see the 1% headline return, and they think that's what their return is going to be for every year going forward, but that's not the case.

"When your 10-year bond rallies 1%, which it did back in Feb and March of 2020, that's a 10% return. That's nothing to sneeze at, said Solomon. 

Invest with confidence